Understanding bond market liquidity

Commentary by Tania Allerton, senior business development manager for Vanguard Asset Management, Limited.

Rising interest rates in the United States, surging popularity for bond exchange-traded funds (ETFs) and new regulations in the post-financial-crisis world are causing concerns about bond market liquidity. But these fears highlight how liquidity is a misunderstood concept.

The growth in fixed income mutual funds and exchange-traded funds is a result of the increasing demand for the asset class. The fear is that large pools of capital are now subject to the whims of unsophisticated investors prone to panic, chase returns and herd into harder-to-trade assets such as higher-yield bonds and bank loans. When these investors overreact and redeem, according to this premise, bond funds will be forced to unload their portfolios into a market that cannot absorb them. The result will be a collapse in bond prices that could spark a systemic crisis.

But even with the tremendous growth in bond investing, mutual funds remain a modest participant in global bond markets. Most bonds are held by central banks, other banks, sovereign wealth funds, hedge funds and a variety of institutional and individual investors. Bond mutual funds represented about 10% of global bond market capitalisation as at December 2013.

These funds overwhelmingly invest in the most liquid, highest quality sectors of the market. The market has demonstrated time and again its ability to find a clearing price for a high-quality security with a certain, well-defined income stream, whether it's issued by the US government or a highly rated corporation.

Millions of individual investors, all with their own time horizons, risk preferences and investment goals, own these funds. This means that unleveraged, high-quality mutual funds acting as agents for a large, diversified group of investors are unlikely to present systemic liquidity or redemption risks to financial markets.

ETFs are overwhelmingly similar to open-ended mutual funds. They allow investors to create low-cost, broadly diversified investment portfolios and to benefit from the economies of scale from collective investing. But rather than trade directly with the open-ended fund once a day at the fund's net asset value, investors can buy or sell ETFs on the secondary market anytime during trading hours. This creates an additional source of liquidity for bond fund investors.

The growth in bond ETFs and mutual funds has created additional capital for organisations seeking to borrow. As banks have re-capitalised in the wake of the financial crisis, they've been less able to make loans to finance investment in the economy. Fixed income funds have provided funding to fill in the gap.

New regulations since the financial crisis have led some banks to retreat from market-making activities in the bond market. Bond dealers' inventories have declined from their 2008 peak and corporate bond turnover has also fallen. Even though these measures remain within historical ranges, they are being used to support the lack-of-liquidity thesis. But they may not actually reveal that much about liquidity. There is no evidence that lower inventory and turnover have had a negative impact on the liquidity metrics that matter most in bond fund management. For example, corporate bond bid-ask spreads, which are an important measure of bond market liquidity, are narrower today than before the global financial crisis.

Experience suggests reasons for optimism about the bond market's ability to match buyers and sellers as different needs arise. Liquidity changes all the time – it has a price that changes with market conditions. Participants in large, broadly diversified markets consistently manage to find a market-clearing price for high-quality securities.

Important information:

This document is directed at professional investors and should not be distributed to, or relied upon by, retail investors. It is designed for use by, and is directed only at, persons resident in the UK.

The information contained in this article is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.

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Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.